Ron Johnson's Biggest Mistake at J.C. Penney

As journalists have begun to write their postmortems of Ron Johnson's turbulent 17-month reign as CEO of J.C. Penney (NYSE: JCP) , there are several common themes. Many argue that Johnson was arrogant to think he could completely reorient consumer psychology, that he was foolish to adopt a new pricing strategy without testing it first, and that he never got the J.C. Penney employee base committed to his new strategy.

There is a good deal of truth to all of these allegations. However, observers should also recognize the extent of the challenge Johnson faced at J.C. Penney. His mandate was to radically transform the company, not just to manage it better. Given that task, it was almost inevitable that there would be major execution challenges.

None of the problems that cropped up following Johnson's strategy change last February were devastating. The real problem was that J.C. Penney's results got worse over the course of Johnson's tenure. This can be traced directly to his decision to double down on everyday pricing last summer. The move to stop offering "Month-Long Values" significantly hurt sales in August and beyond, overwhelming any benefits from the initial rollout of Johnson's in-store "shops." This mistake, more than any other, caused his downfall.

Initial plan and initial resultsRon Johnson's original pricing strategy for J.C. Penney involved three pricing tiers: "Everyday" low prices, "Month-Long Values" for seasonally appropriate merchandise, and "Best Prices" for clearance merchandise. The "Month-Long Values" were the equivalent of sale merchandise in this scheme. Johnson believed that holding 12 month-long sales events rather than hundreds of different promotions would reduce staffing needs while giving customers the flexibility to shop when they wanted.

The initial results disappointed both investors and management. In first-quarter 2012, the first quarter of the transformation, the company posted an adjusted loss of $0.25. Sales dropped by 20.1% and gross margin slipped to 37.6% due to markdowns of old inventory. However, the company cut costs significantly during the quarter, and executives still expected to post a sizable profit for the full year as of mid-May.

The next quarter dashed those plans, as sales dropped by 22.6% and gross margin fell to 33.2% on continued inventory markdowns, leading to a slightly bigger adjusted net loss of $0.37. The weak sales performance was attributed in part to lower marketing activity as Johnson and his team worked to retool the marketing message.

J.C. Penney therefore withdrew its previous guidance for a full-year adjusted profit, but management and investors were still excited about the company's prospects entering the back-to-school season. After all, the company rolled out its first set of "shops" in late July, with more scheduled to open in late August. These merchandising improvements were expected to offset much of the weakness in the rest of the store.

The big mistakeJ.C. Penney's results in the first half of 2012 were clearly disappointing, but the company's losses were moderate. There were no serious doubts about whether the company could survive. However, Johnson misdiagnosed the cause of J.C. Penney's weak sales trends. Johnson believed that customers were confused by the "Month-Long Values," because putting some items on sale every month made the "Everyday" merchandise seem pricey by comparison.

As a result, Johnson decided to get rid of the "Month-Long Values" price tier. All merchandise became either "Everyday" or "clearance" as of Aug. 1. However, customers really wanted more sales and the return of coupons. This caused a steep drop-off in sales and profitability in the third quarter (sales down 26.6%, adjusted loss of $0.93 per share) and the fourth quarter (sales down 28.4%, adjusted loss of $1.95 per share). The sales declines came in spite of strong sales in the new "shops."

The extent of the deterioration was made clear by J.C. Penney's recently reported first-quarter 2013 results. This was the first quarter of "easy comps," and provides a direct comparison between the results of Johnson's original pricing strategy and the revamped strategy. Sales decreased 16.4% and the adjusted loss of $1.31 per share was far worse than the $0.25 loss per share experienced in the first quarter of J.C. Penney's transformation.

Foolish conclusionWhile Johnson made a lot of mistakes at J.C. Penney, none can really compare to his misreading of the initial reception of his plans. In August, rather than stepping up promotional activity to improve sales, Johnson decided to double down on the "Everyday" pricing strategy. This was clearly the wrong reaction. Only after this change did J.C. Penney's performance turn from weak to disastrous, putting the company's survival in doubt. Ultimately, this was the final mistake that sealed Johnson's fate, paving the way for Mike Ullman's return to the CEO post last month.

Could Ullman present the opportunity investors have been waiting for? If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about Penney's turnaround -- or lack thereof. Simply click here now for instant access.

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